Costs Of Inflation

Question 1

What two groups are the main costs of inflation divided into?

Answer 1

• Anticipated Costs
• Unanticipated Costs

Question 2

What are the main anticipated costs of inflation?

Answer 2

• inflation as a tax on RMB
• Menu costs
• Costs relating to nominal debt contracts
• Incomplete indexation of taxes

Question 3

Describe main effect of inflation as a tax on RMB?

Answer 3

• higher inflation leads to higher interest rates ( all else constant) which = higher opportunity costs of holding RMB
• leads to bonds becoming relatively more attractive
• increase in transaction costs (shoe leather) causing reduction in leisure and hence loss in social welfare

Question 4

What are menu costs?

Answer 4

• all costs associated with changing prices

Question 5

Main impact of inflation on menu costs?

Answer 5

• inflation increase leads to increased rate of price changes
• leads to higher menu costs and possible trading at non equilibrium prices
• greater price variability

Question 6

Describe the effect of inflation on nominal debt contracts?

Answer 6

• inflation increases nominal interest rate
• leads to increase in real cost of servicing loan
• reduces borrowing by firms and households

Question 7

What is tax indexation?

Answer 7

• adjusts the amount of an assets costs by the rate of inflation

Question 8

Describe effects of inflation on incomplete indexation of taxes

Answer 8

• inflation increases nominal incomes and nominal capital gains
• results in movement to higher tax bands, firms paying more tax even if real value or income/profits is unchanged
• reduced welfare
• workers may reduce hours of labour
• firms may reduce investment as any profits heavily taxed

Question 9

What are the main unanticipated costs of inflation?

Answer 9

• Variable relative prices
• Redistribution of Wealth between borrowers and lenders
• Longer term contracts and risk ore is

Question 10

Describe effect of inflation on Variable relative prices

Answer 10

• high inflation leads to more variable inflation
• more volatile inflation leads to increased price variability
• harder to distinguish between absolute and relative prices
• role of menu costs plays role
• price mechanism becomes inefficient
• incorrect decisions made during production, investment and consumption

Question 11

What is a further impact of high inflation(volatile inflation)?

Answer 11

• increased uncertainty of firms
• firms likely to postpone investment until inflation is lower and more stable

Question 12

Redistributive effects of inflation

Answer 12

• when inflation is higher than anticipated
• real cost of debt falls
• benefits borrowers
• disbenefits lenders

Question 13

Further impact of uncertainty regarding future inflation on lenders and borrowers?

Answer 13

• uncertainty regarding future inflation discourages lenders from lending at fixed nominal rates over the long term
• lenders need to be compensated
• this increases cost of borrowing as lenders require risk premium

Question 14

Relationship between inflation and growth

Answer 14

• careful identification suggests negative relationship between inflation and growth
• more particularly when inflation is very high

Question 15

What is deflation?

Answer 15

• negative inflation
• I.e prices falling

Question 16

Main cost of deflation?

Answer 16

• if deflation is expected households are likely to delay consumption, especially on durables
• firms and households also likely to delay borrowing (real costs of debt rises)
• results in reduction in output, investment and consumption
• could be recessionary

Question 17

What is Zero Lower Bound (ZLB)?

Answer 17

• expansionary MP tool where CB lowers short-term interest rates to zero, if needed, to stimulate the economy

Question 18

Why might positive inflation target be more beneficial than zero inflation target?

Answer 18

• if there is a zero inflation target MP more likely to become ineffective at ZLB
• nominal wage rigidity may be more costly when inflation is low/zero
• nominal wages are sticky downwards (workers more likely to resist nominal wage decrease) but real wages less so (workers less resistant)
• greater flexibility to reduce wages when inflation > 0

Question 19

How are indices calculated?

Answer 19

• using a representative bundle of goods and services

Question 20

What are some biases in inflation measured (related to price indices)?

Answer 20

1. Quality improvements - goods and services improve in quality through time without price rising (overestimation)
2. Substitution bias - as inflation increased consumer switch to cheaper products - basket changes
3. Outlet bias - consumers look for best deals/switch between to cheaper shops
4. Logarithm bias